{"id":28347,"date":"2024-03-06T12:54:17","date_gmt":"2024-03-06T17:54:17","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/?post_type=biws_kb&#038;p=28347"},"modified":"2024-09-02T18:00:56","modified_gmt":"2024-09-02T23:00:56","slug":"roic-return-on-invested-capital","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/roic-return-on-invested-capital\/","title":{"rendered":"ROIC (Return on Invested Capital): Beyond the Investopedia Treatment"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">ROIC (Return on Invested Capital): Beyond the Investopedia Treatment<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/roic-return-on-invested-capital\/#Video_Table_of_Contents\">Video Table of Contents:<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/roic-return-on-invested-capital\/#ROIC_Calculation_and_the_ROIC_Formula_in_More_Detail\">ROIC Calculation and the ROIC Formula in More Detail<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/roic-return-on-invested-capital\/#ROIC_in_LBO_and_DCF_Models\">ROIC in LBO and DCF Models<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/roic-return-on-invested-capital\/#Issues_with_ROIC_and_Its_Use_in_Models\">Issues with ROIC and Its Use in Models<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-5\" href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/roic-return-on-invested-capital\/#Final_Thoughts_on_the_ROIC_Metric\">Final Thoughts on the ROIC Metric<\/a><\/li><\/ul><\/nav><\/div>\n\n<blockquote><p><strong>ROIC (Return on Invested Capital) Definition:<\/strong> Return on Invested Capital equals a company\u2019s Net Operating Profits After Taxes (NOPAT) in a period divided by its <em>Average<\/em> Invested Capital in that period, where Invested Capital consists of Debt + Equity + Other Long-Term Funding Sources, such as Preferred Stock; ROIC tells you how efficiently a company is using its total capital to generate profits.<\/p><\/blockquote>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-28348 size-full\" title=\"ROIC Definition\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125136\/01-ROIC-Definition.jpg\" alt=\"ROIC Definition\" width=\"2028\" height=\"784\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125136\/01-ROIC-Definition.jpg 2028w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125136\/01-ROIC-Definition-300x116.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125136\/01-ROIC-Definition-1024x396.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125136\/01-ROIC-Definition-768x297.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125136\/01-ROIC-Definition-1536x594.jpg 1536w\" sizes=\"(max-width: 2028px) 100vw, 2028px\" \/><\/p>\n<p><a href=\"https:\/\/breakingintowallstreet.com\/kb\/valuation\/nopat\/\" target=\"_blank\" rel=\"noopener\">NOPAT<\/a> is defined as <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/ebit-operating-income\/\" target=\"_blank\" rel=\"noopener\">Operating Income<\/a> * (1 \u2013 Tax Rate) and should ideally be adjusted for non-recurring charges; see the articles on <a href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/non-recurring-expenses\/\" target=\"_blank\" rel=\"noopener\">non-recurring expenses<\/a> and <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/ebitda\/\" target=\"_blank\" rel=\"noopener\">EBITDA<\/a> for more.<\/p>\n<p>You can see a simple ROIC calculation for Best Buy below:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-28349 size-full\" title=\"ROIC Calculation for Best Buy\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125201\/02-Best-Buy-ROIC.jpg\" alt=\"ROIC Calculation for Best Buy\" width=\"1396\" height=\"860\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125201\/02-Best-Buy-ROIC.jpg 1396w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125201\/02-Best-Buy-ROIC-300x185.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125201\/02-Best-Buy-ROIC-1024x631.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125201\/02-Best-Buy-ROIC-768x473.jpg 768w\" sizes=\"(max-width: 1396px) 100vw, 1396px\" \/><\/p>\n<p>If two companies are similar, but one has a higher ROIC, the company with a higher ROIC should, in theory, trade at higher <a href=\"https:\/\/breakingintowallstreet.com\/kb\/valuation\/valuation-multiples\/\" target=\"_blank\" rel=\"noopener\">valuation multiples<\/a> (e.g., P \/ E, TEV \/ EBITDA, etc.).<\/p>\n<p>The fact that Best Buy trades at <em>lower<\/em> multiples than Target despite a much higher ROIC gives us a hint that something may be \u201coff\u201d with their valuations:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-28350 size-full\" title=\"ROIC Calculations for Best Buy vs. Target\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125231\/03-Best-Buy-Target-ROIC-Comparison-scaled.jpg\" alt=\"ROIC Calculations for Best Buy vs. Target\" width=\"2560\" height=\"378\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125231\/03-Best-Buy-Target-ROIC-Comparison-scaled.jpg 2560w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125231\/03-Best-Buy-Target-ROIC-Comparison-300x44.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125231\/03-Best-Buy-Target-ROIC-Comparison-1024x151.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125231\/03-Best-Buy-Target-ROIC-Comparison-768x114.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125231\/03-Best-Buy-Target-ROIC-Comparison-1536x227.jpg 1536w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125231\/03-Best-Buy-Target-ROIC-Comparison-2048x303.jpg 2048w\" sizes=\"(max-width: 2560px) 100vw, 2560px\" \/><\/p>\n<p>You often use ROIC to cross-check your assumptions in a <a href=\"https:\/\/mergersandinquisitions.com\/3-statement-model\/\" target=\"_blank\" rel=\"noopener\">3-statement<\/a>, <a href=\"https:\/\/mergersandinquisitions.com\/dcf-model\/\" target=\"_blank\" rel=\"noopener\">DCF<\/a>, or <a href=\"https:\/\/mergersandinquisitions.com\/lbo-modeling-test\/\" target=\"_blank\" rel=\"noopener\">LBO model<\/a>, and see if something like a higher exit multiple is justified.<\/p>\n<div class='code-block code-block-2' style='margin: 8px 0; clear: both;'>\n<div class=\"kb-adinsert-modal\">\n    <div class=\"kb-adinsert-top\">\n      <div class=\"media\">\n          <img decoding=\"async\" class=\"alignnone size-full wp-image-28448\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/04\/24164120\/adv-fm-tile.png\" alt=\"PowerPoint Pro\" width=\"128\" height=\"128\" \/>\n      <\/div>\n      <div class=\"content\">\n          <h3>Master Financial Modeling for Investment Banking With <strong>BIWS Core Financial Modeling<\/strong><\/h3>\n      <\/div>\n    <\/div>\n    \n    <div class=\"full_text\">\n    \t<ul>\n        \t<li>\n            \t<h4>Become a financial modeling pro<\/h4>\n              <p>158 videos, detailed written guides, Excel files, quizzes, and more<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Complete 10+ detailed global case studies<\/h4>\n            <p>These include both the theory and the practical applications<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Prepare for your internship or full-time job<\/h4>\n            <p>Gain the skills you need to \u201chit the ground running\u201d on Day 1\n\n<\/p>\n\t\t\t  <\/li>\n      <\/ul>\n        \n      <a class=\"cta-link orange-button-medium\" href=\"https:\/\/breakingintowallstreet.com\/core-financial-modeling\/\" target=\"_blank\">Full Details<\/a>\n      \n      <a class=\"cta-link orange-button-medium bg-blue\" href=\"https:\/\/biws-support.s3.us-east-1.amazonaws.com\/Course-Outlines\/Core-Financial-Modeling-Course-Outline.pdf\" target=\"_blank\" rel=\"noopener\">Short Outline<\/a>\n    <\/div>\n<\/div><\/div>\n\n<p>For example, if a private equity firm buys a company for 10x EBITDA and plans to sell it for 12x EBITDA, can you justify this assumption based on an increasing ROIC over the holding period?<\/p>\n<p>If not, you may need to revisit your assumptions.<\/p>\n<p>While ROIC is a useful metric, <strong>it is also defined inconsistently<\/strong>, it\u2019s less meaningful for certain industries and company types, and it\u2019s not always practical to use since it requires projections for both Debt and Equity.<\/p>\n<h3><strong>Files &amp; Resources:<\/strong><\/h3>\n<p><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/Financial-Statement-Analysis\/ROIC\/101-04-Return-on-Invested-Capital-Slides.pdf\" target=\"_blank\" rel=\"noopener\">ROIC &#8211; Slide Presentation (PDF)<\/a><\/p>\n<p><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/Financial-Statement-Analysis\/ROIC\/101-04-NOPAT-ROIC.xlsx\" target=\"_blank\" rel=\"noopener\">NOPAT and ROIC Calculations for Target and Best Buy (XL)<\/a><\/p>\n<p><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/Financial-Statement-Analysis\/ROIC\/101-04-ROIC-in-LBO-Model.xlsx\" target=\"_blank\" rel=\"noopener\">ROIC in a Simple LBO Model (XL)<\/a><\/p>\n<p><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/Financial-Statement-Analysis\/ROIC\/101-04-Best-Buy-10-K-Extracts.pdf\" target=\"_blank\" rel=\"noopener\">Best Buy &#8211; Key Extracts from 10-K (PDF)<\/a><\/p>\n<p><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/Financial-Statement-Analysis\/ROIC\/101-04-Target-10-K-Extracts.pdf\" target=\"_blank\" rel=\"noopener\">Target &#8211; Key Extracts from 10-K (PDF)<\/a><\/p>\n<h2><span class=\"ez-toc-section\" id=\"Video_Table_of_Contents\"><\/span><strong>Video Table of Contents:<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p><strong>0:52:<\/strong> The Short Answer About ROIC<\/p>\n<p><strong>4:53:<\/strong> Part 1: ROIC Calculations for Target and Best Buy<\/p>\n<p><strong>8:08:<\/strong> Part 2: ROIC in LBO and DCF Models<\/p>\n<p><strong>9:26:<\/strong> Part 3: Issues with ROIC and Its Use in Models<\/p>\n<p><strong>11:08:<\/strong> Recap and Summary<\/p>\n<h2><span class=\"ez-toc-section\" id=\"ROIC_Calculation_and_the_ROIC_Formula_in_More_Detail\"><\/span><strong>ROIC Calculation and the ROIC Formula in More Detail<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>The basic formula for ROIC is simple:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-28351 size-full\" title=\"ROIC Formula\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125249\/04-ROIC-Formula.jpg\" alt=\"ROIC Formula\" width=\"2332\" height=\"318\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125249\/04-ROIC-Formula.jpg 2332w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125249\/04-ROIC-Formula-300x41.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125249\/04-ROIC-Formula-1024x140.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125249\/04-ROIC-Formula-768x105.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125249\/04-ROIC-Formula-1536x209.jpg 1536w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125249\/04-ROIC-Formula-2048x279.jpg 2048w\" sizes=\"(max-width: 2332px) 100vw, 2332px\" \/><\/p>\n<p>You should use the <strong>book value<\/strong> of each item in the denominator \u2013 in other words, each item\u2019s value on the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/balance-sheet\/\" target=\"_blank\" rel=\"noopener\">Balance Sheet<\/a>, <em>not<\/em> its market value.<\/p>\n<p>You use the market value of Debt and Equity in the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/equity-value-enterprise-value\/how-to-calculate-enterprise-value\/\" target=\"_blank\" rel=\"noopener\">Enterprise Value calculation<\/a>, but not in ROIC because you\u2019re assessing the company\u2019s efficiency based on <strong>its total capital raised or generated<\/strong>.<\/p>\n<p>The market value of this capital is irrelevant because it doesn\u2019t represent <em>the company\u2019s initial actions<\/em> to get this capital.<\/p>\n<p>There are a few other questions with this calculation:<\/p>\n<h3><strong>Q1: Which non-recurring charges do you add back to calculate Operating Income or EBIT?<\/strong><\/h3>\n<p><strong>A:<\/strong> We recommend being quite conservative here and adding back only <em>true<\/em> non-recurring expenses, such as those appearing in only 1 out of 5 historical years.<\/p>\n<p>For more, see <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/ebitda\/\" target=\"_blank\" rel=\"noopener\">our EBITDA tutorial.<\/a><\/p>\n<h3><strong>Q2: Which Tax Rate do you use?<\/strong><\/h3>\n<p><strong>A:<\/strong> If there have been no major changes, we prefer the historical average over the past 3 \u2013 5 years.<\/p>\n<p>If you get a nonsensical result, such as a (25%) or 75% tax rate, you could use the statutory corporate tax rate in the company\u2019s country.<\/p>\n<h3><strong>Q3: What about Leases? Do you subtract Cash in the Invested Capital calculation?<\/strong><\/h3>\n<p><strong>A:<\/strong> We prefer <strong>not<\/strong> to subtract Cash in the ROIC calculation because doing so often inflates ROIC for companies with high Cash balances.<\/p>\n<p>It also creates comparability issues between companies with high vs. low Cash numbers.<\/p>\n<p>You could subtract Cash if you want, but if you do so, you must apply the rule consistently to all the comparable companies you\u2019re analyzing.<\/p>\n<p>Leases and <a href=\"https:\/\/mergersandinquisitions.com\/lease-accounting\/\" target=\"_blank\" rel=\"noopener\">lease accounting<\/a> are complex issues, but for <strong>U.S.-based companies that follow U.S. GAAP<\/strong>, we generally do <strong>not<\/strong> add Lease Liabilities to Invested Capital.<\/p>\n<p>That\u2019s because if we add them, we must adjust EBIT by adding back the associated Rental Expense \u2013 and to make it even more confusing, some companies calculate and define this expense differently.<\/p>\n<p>For example, some firms add back just the &#8220;estimated Interest portion&#8221; rather than the entire Rental Expense, which is incorrect because the Lease Liability represents the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/finance\/present-value\/\" target=\"_blank\" rel=\"noopener\">Present Value<\/a> of the <em>full<\/em> Rental Expense over its term.<\/p>\n<p><a href=\"https:\/\/breakingintowallstreet.com\/kb\/valuation\/us-gaap-vs-ifrs-in-valuation-and-financial-modeling\/\" target=\"_blank\" rel=\"noopener\">If the company follows IFRS accounting rules<\/a>, you need to address leases in the calculations because the expenses for Operating and Finance Leases are split into Lease Interest and Lease Depreciation.<\/p>\n<p>You have two main options here:<\/p>\n<p><strong>Option #1:<\/strong> Add the Lease Liabilities to Invested Capital and <em>add back<\/em> the Lease Depreciation to EBIT so that it\u2019s \u201cEBIT Before the Lease Expense.\u201d<\/p>\n<p><strong>Option #2:<\/strong> Do <strong>not<\/strong> add the Lease Liabilities to Invested Capital and <em>deduct<\/em> the Lease Interest from EBIT so that it\u2019s \u201cEBIT After the Lease Expense.\u201d<\/p>\n<p>If we adjust Target and Best Buy\u2019s numbers by adding the full Lease Liabilities and adding back the full Rental Expense, we get the following results:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-28352 size-full\" title=\"ROIC - Lease and Cash Adjustments\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125333\/05-ROIC-Lease-Adjustment-scaled.jpg\" alt=\"ROIC - Lease and Cash Adjustments\" width=\"2560\" height=\"1032\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125333\/05-ROIC-Lease-Adjustment-scaled.jpg 2560w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125333\/05-ROIC-Lease-Adjustment-300x121.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125333\/05-ROIC-Lease-Adjustment-1024x413.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125333\/05-ROIC-Lease-Adjustment-768x310.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125333\/05-ROIC-Lease-Adjustment-1536x619.jpg 1536w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125333\/05-ROIC-Lease-Adjustment-2048x826.jpg 2048w\" sizes=\"(max-width: 2560px) 100vw, 2560px\" \/><\/p>\n<p>The difference isn\u2019t huge, but the gap between these companies narrows as Best Buy\u2019s ROIC falls and Target\u2019s ROIC only falls slightly.<\/p>\n<p>Since Leases are far more important for Best Buy <em>on a relative basis<\/em>, the lease adjustments may be warranted in this case, even though both companies follow U.S. GAAP and, therefore, use simplified accounting for their Operating Leases.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"ROIC_in_LBO_and_DCF_Models\"><\/span><strong>ROIC in LBO and DCF Models<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>The ROIC metric lets you \u201csanity-check\u201d your long-term forecasts in leveraged buyout and discounted cash flow models<strong>.<\/strong><\/p>\n<p>For example, if you assume a higher exit multiple in a <a href=\"https:\/\/mergersandinquisitions.com\/3-statement-model\/\" target=\"_blank\" rel=\"noopener\">3-statement model<\/a> or <a href=\"https:\/\/mergersandinquisitions.com\/lbo-modeling-test\/\" target=\"_blank\" rel=\"noopener\">LBO model<\/a>, does the company\u2019s ROIC increase over the holding period?<\/p>\n<p>If not, you must revisit the assumptions because your forecast may not support this multiple expansion.<\/p>\n<p>For example, in this 3-statement model for Coles, a grocery retailer in Australia, we assume a higher exit multiple (~10x to ~12x), but the ROIC (or \u201cReturn on Capital\u201d) also increases from ~15% to ~20% over the period:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-28353 size-full\" title=\"ROIC and Exit Multiple Expansion for Coles\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125350\/06-ROIC-Coles-Exit-Multiple.jpg\" alt=\"ROIC and Exit Multiple Expansion for Coles\" width=\"1920\" height=\"1016\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125350\/06-ROIC-Coles-Exit-Multiple.jpg 1920w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125350\/06-ROIC-Coles-Exit-Multiple-300x159.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125350\/06-ROIC-Coles-Exit-Multiple-1024x542.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125350\/06-ROIC-Coles-Exit-Multiple-768x406.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/03\/06125350\/06-ROIC-Coles-Exit-Multiple-1536x813.jpg 1536w\" sizes=\"(max-width: 1920px) 100vw, 1920px\" \/><\/p>\n<p>If the ROIC stayed the same, this increased exit multiple would be much harder to justify.<\/p>\n<p>In a <a href=\"https:\/\/mergersandinquisitions.com\/dcf-model\/\" target=\"_blank\" rel=\"noopener\">DCF model<\/a>, you generally want the ROIC to decline and move closer to the company\u2019s <a href=\"https:\/\/mergersandinquisitions.com\/wacc-formula\/\" target=\"_blank\" rel=\"noopener\">Weighted Average Cost of Capital (WACC)<\/a> over time.<\/p>\n<p>Even if the company\u2019s ROIC is high initially, such as 30 \u2013 40%, it should not remain at that level indefinitely against a much lower WACC, such as 10 \u2013 12%.<\/p>\n<p>You may still see a difference going into the <a href=\"https:\/\/breakingintowallstreet.com\/how-to-calculate-terminal-value\/\" target=\"_blank\" rel=\"noopener\">Terminal Period<\/a>, but ROIC should be closer to WACC by then.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Issues_with_ROIC_and_Its_Use_in_Models\"><\/span><strong>Issues with ROIC and Its Use in Models<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Even though ROIC is useful, it\u2019s not especially common in investment banking or banking-style models presented in <a href=\"https:\/\/mergersandinquisitions.com\/investment-banking-pitch-books\/\" target=\"_blank\" rel=\"noopener\">pitch books<\/a>.<\/p>\n<p>A few factors explain this:<\/p>\n<p><strong>Issue #1: Inconsistent Definitions and Calculations<\/strong> \u2013 See all the issues above with Cash and Lease Liabilities. Many companies also have their \u201cown versions,\u201d such as Return on Capital Employed (ROCE), Return on Capital (ROC), and others.<\/p>\n<p>These discrepancies make \u201capples-to-apples\u201d comparisons difficult in some cases.<\/p>\n<p><strong>Issue #2: Not Meaningful for All Companies<\/strong> \u2013 ROIC is the most useful for large, mature companies growing at moderate-to-slow rates.<\/p>\n<p>It\u2019s not relevant for tech or biotech startups, and it\u2019s not used in sectors such as <a href=\"https:\/\/mergersandinquisitions.com\/financial-institutions-group\/\" target=\"_blank\" rel=\"noopener\">financial institutions<\/a> or <a href=\"https:\/\/mergersandinquisitions.com\/real-estate-investment-banking-group\/\" target=\"_blank\" rel=\"noopener\">real estate (REITs)<\/a>.<\/p>\n<p><strong>Issue #3: Extra Work<\/strong>\u2014If you have a simple \u201ccash flow only\u201d model, you\u2019ll need to complete additional work to forecast the company\u2019s Debt and Equity balances.<\/p>\n<p>You can easily calculate the historical ROIC, but this is not especially useful in models; you need the <em>projected<\/em> numbers to check your assumptions.<\/p>\n<p><strong>Issue #4: The Client is Always Right<\/strong> \u2013 In <a href=\"https:\/\/mergersandinquisitions.com\/investment-banking\/\" target=\"_blank\" rel=\"noopener\">investment banking<\/a>, you always do what the client wants because the client is paying your bank huge sums of money for advisory services.<\/p>\n<p>So, even if ROIC indicates that your client\u2019s assumptions are nonsensical, you must follow them \u2013 or risk losing the client.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Final_Thoughts_on_the_ROIC_Metric\"><\/span><strong>Final Thoughts on the ROIC Metric<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Because of all the factors above, ROIC is a more useful metric when you\u2019re <strong>in a \u201ccritical thinking\u201d-oriented role on the buy-side<\/strong>, such as at a <a href=\"https:\/\/mergersandinquisitions.com\/hedge-funds\/\" target=\"_blank\" rel=\"noopener\">hedge fund<\/a>, <a href=\"https:\/\/mergersandinquisitions.com\/asset-management\/\" target=\"_blank\" rel=\"noopener\">asset management firm<\/a>, or <a href=\"https:\/\/mergersandinquisitions.com\/private-equity\/\" target=\"_blank\" rel=\"noopener\">private equity firm<\/a>.<\/p>\n<p>In these roles, you can assess company-provided information, pick apart assumptions, and find holes in their logic.<\/p>\n<p>But like any other valuation metric, ROIC is just one tool; it can reveal pricing discrepancies and flawed business plans, but it doesn\u2019t \u201cprove\u201d anything by itself.<\/p>\n<p>You should use ROIC <u>with<\/u> valuation multiples, the DCF model, and scenario analysis to decide which companies and deals are worth investing in.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Return on Invested Capital equals a company\u2019s Net Operating Profits After Taxes (NOPAT) in a period divided by its Average Invested Capital in that period, where Invested Capital consists of Debt + Equity + Other Long-Term Funding Sources, such as Preferred Stock; ROIC tells you how efficiently a company is using its total capital to generate profits.<\/p>\n","protected":false},"featured_media":29059,"template":"","class_list":["post-28347","biws_kb","type-biws_kb","status-publish","has-post-thumbnail","hentry","kb_category-financial-statement-analysis"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/28347","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media\/29059"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=28347"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}